What Is a Mortgage and How Does It Work?

Learn How Mortgages and Mortgage Loans Work

If you have any interest in purchasing a home someday, you’ve probably heard of a mortgage. A mortgage is a type of loan used to buy residential or commercial real estate, but how are they different from other loans? This guide explains exactly how a mortgage loan works, including what types of loans are available and what it costs to borrow.

What Is a Mortgage?

A mortgage is a loan used to buy property. Mortgages often have affordable interest rates and long repayment terms, generally 15 to 30 years. A mortgage loan can be used to buy residential real estate, like a home, or commercial property, like office buildings. Mortgages differ from other loans because the property guarantees the debt as collateral. If you don't pay, you are at risk of losing the property.

Types of Mortgages

There are quite a few different kinds of mortgages. Here are some of the most common loan types used for property purchases.

• FHA Loans: FHA loans are insured by the Federal Housing Administration so applicants can qualify with lower credit scores and low down payments, although they must pay for mortgage insurance.
• VA Loans: VA loans are guaranteed by the Department of Veterans Affairs and offer qualifying veterans or service members affordable rates and flexible requirements, including no down payment and the ability to qualify with lower credit.
• USDA Loans: USDA loans are guaranteed by the United States Department of Agriculture and offer affordable interest rates and flexible eligibility requirements to those purchasing homes in rural areas.
• Conventional Loans: Conventional loans aren't guaranteed by the government so they can be more difficult to qualify for, but they are more widely available and often charge lower fees.

Loans guaranteed or backed by the government are still offered by private lenders. The government just insures them, which protects the lender if a borrower fails to pay. This means the lender faces less risk and can make the qualification process easier for prospective borrowers.

What Can a Mortgage Be Used for?

Mortgages are specifically designed for the purchase of real estate.

• Residential mortgage loans are used to buy properties such as a house, condo, or apartment. You can also use a residential mortgage to buy small multi-family properties with four units or fewer. These loans usually offer lower rates and longer terms than commercial loans.
• Commercial mortgages are used to buy properties for business purposes, such as warehouses, office buildings, or multi-family housing with five units or more. Loans usually have shorter terms and higher rates. Freedom Mortgage does not offer loans for commercial properties.

You can't use a mortgage to buy land -- you'll need a special land loan for that, which typically comes at a higher rate. And, while you can use a mortgage loan to build a house, you need a special construction loan that has a relatively short repayment term. The goal is to get your house built during the initial loan term, then get a new mortgage loan on the finished property to pay off the construction loan.

Mortgages can't be used to buy personal property, which includes cars, furniture, and anything that can move with you if you relocate. However, if your home is worth more than you owe, you may be able to get a cash-out refinance to take some equity out. If you do, you can use that money for anything you want.

How Do Mortgages Work?

Mortgages are loans from financial institutions, and lenders set rules on who can borrow. For some loans, called "conforming loans," eligibility rules are based on guidelines from Fannie Mae and Freddie Mac (government-sponsored entities that resell mortgages to investors). Other non-conforming loans, such as jumbo loans, may have different requirements.

When you apply for a mortgage, you want to show the lender that you meet their requirements. Many people obtain a prequalification or provide financial documents to get preapproval before shopping for a home. The lender typically reviews pay stubs, bank statements, and other details to determine whether to approve the loan and how much to lend.

When you find a home, the lender arranges for an appraisal to determine the property's value and confirm it's worth enough to guarantee the loan. You can usually borrow up to a specific percentage of the property value, with the amount varying by lender (usually from 80% to 100% of the home's market value).

You also must decide on loan terms. This may mean choosing between common terms like a 15- or 30-year loan, and between a fixed or adjustable-rate mortgage (ARM). Our mortgage glossary defines these terms, but essentially, fixed rates stay the same for the life of the loan so principal and interest payments don't change, while interest rates change on an ARM and payments could rise or fall. Monthly payments are also higher with a 15-year loan versus a 30-year loan, although total interest costs are lower.

Once you choose a loan and receive final approval, closing takes place. You’ll bring the down payment and other funds needed to cover the required closing costs. Those are usually things like state transfer taxes. The down payment and money from the mortgage are transferred to the seller at closing.

After closing, you’re officially a homeowner with a mortgage loan that must be repaid with monthly payments.

Mortgage Payments

When you take out a mortgage, you commit to make monthly mortgage payments over time, with a popular loan term being 30 years.

Mortgage payments are made up of at least two, though usually more, different costs:

• Principal: This is the balance you owe. Each month, some of your mortgage payment goes toward reducing your balance.
• Interest: This is what you pay for borrowing. If you have a 4% interest rate, less of your money goes to interest than if you have a 7% rate.
• Property Taxes: Some mortgage lenders require you to escrow your taxes, and you may choose to escrow even if it's not required. When you escrow taxes, you pay a little each month toward them, instead of making one large payment. The money is kept safe until the tax bill comes due and is paid by the lender.
• Homeowner’s Insurance: Some mortgage lenders also require you to escrow insurance payments for your homeowner's insurance. You can also choose to use this chance to pay for premiums over time instead of paying all at once.

If you made a small down payment (under 20%) or took out certain types of mortgage loans, such as an FHA loan, you may also have to pay monthly mortgage insurance premiums. These buy insurance that protects the lender against losing money in foreclosure.

Here's how this works. Say you buy a $400,000 home with a 10% down payment, a 30-year loan term, and a 6.5% interest rate. You have property taxes of 1.2% of the home's value, $1,500 per year in home insurance premiums, and annual private mortgage insurance premiums of $4,000. There's no HOA fee. Your monthly payment would look like this:

• $2,275.44 paid per month
  • $1,417.44 to principal and interest
  • $400.00 to escrow for property tax
  • $125.00 to escrow for home insurance
  • $333.33 for mortgage insurance

Mortgage payments are amortized over the life of the loan. Each payment is designed to pay enough toward principal and interest that you will have a $0 balance at the end of your loan term. Understanding amortization is a key part of understanding the mortgage loan definition.

Mortgages are structured so you pay more interest up front. Most of your payment will go to interest at the beginning. Over time, as your principal balance goes down interest costs will also decline, and the amount going to principal will increase.

Mortgage Interest Rates

Mortgage interest rates determine how much a mortgage costs.

Rates are determined by many factors, including economic conditions and financial criteria. You can also choose between a fixed or adjustable-rate mortgage (ARM).

• Fixed-rate mortgages: Your rate and principal and interest payment will never change. You know up front how much your loan costs each month for the life of the loan.
• ARMs: You’ll lock in your rate for a set time, such as 5, 7, or 10 years. After that, rates adjust on schedule. Rates are tied to a financial index, like the prime rate. A loan that locks in your rate for five years and then adjusts annually is called a 5/1 ARM, while one that locks in your rate for seven years is called a 7/1 ARM.

ARMs often, but not always, have a lower starting rate. This can make them attractive, but it’s important to remember that if rates go up, your payment will too, since you'll have to pay more interest while also paying the principal down enough to repay your loan on schedule.

Mortgage Eligibility and Approval

Remember, lenders set their own eligibility criteria for mortgage loans. Lenders usually consider your:

• Credit score
• Income
• Debt-to-income ratio, a comparison of your debt relative to your earnings
• Employment history, preferably of two years
• Down payment amount

Since the home is the collateral to guarantee the debt, it also must appraise for enough to cover the loan and meet other requirements such as being safe and habitable.

The best way to know if you'll be eligible for a loan is to get prequalified. Learn how to apply for a mortgage loan today so you can get started.

Get Prequalified with Freedom Mortgage Today

If you think you're ready to use a mortgage loan to buy real estate of your own, reach out to Freedom Mortgage today to start the process of prequalification. We'll help you through every step and find a loan that's right for you.